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1. An Overview of Corporate11Finance and the FinancialEnvironment In a beauty contest for companies, the winner is . . . General Electric. Or at least General Electric is the most admired company in America, accordingto Fortune magazines annual survey. The other top ten nalists are Cisco Systems, Wal-Mart Stores, Southwest Airlines, Microsoft, Home Depot, Berkshire Hathaway, CharlesSchwab, Intel, and Dell Computer. What do these companies have that separates themfrom the rest of the pack? According to more than 4,000 executives, directors, and security analysts, thesecompanies have the highest average scores across eight attributes: (1) innovativeness,(2) quality of management, (3) employee talent, (4) quality of products and services,(5) long-term investment value, (6) nancial soundness, (7) social responsibility, and (8)use of corporate assets. These companies also have an incredible focus on using technology to reducecosts, to reduce inventory, and to speed up product delivery. For example, workers atDell previously touched a computer 130 times during the assembly process but nowSee http://www.fortune. touch it only 60 times. Using point-of-sale data, Wal-Mart is able to identify and meet sur-com for updates on the U.S. prising customer needs, such as bagels in Mexico, smoke detectors in Brazil, and houseranking. Fortune also ranks paint during the winter in Puerto Rico. Many of these companies are changing the waythe Global Most Admired.business works by using the Net, and that change is occurring at a break-neck pace. Forexample, in 1999 GEs plastics distribution business did less than $2,000 per day of busi-ness online. A year later the division did more than $2,000,000 per day in e-commerce. Many companies have a difcult time attracting employees. Not so for the mostadmired companies, which average 26 applicants for each job opening. This is because,in addition to their acumen with technology and customers, they are also on the leadingedge when it comes to training employees and providing a workplace in which peoplecan thrive. In a nutshell, these companies reduce costs by having innovative productionprocesses, they create value for customers by providing high-quality products andservices, and they create value for employees through training and fostering an envi-ronment that allows employees to utilize all of their skills and talents. Do investors benet from this focus on processes, customers, and employees?During the most recent ve-year period, these ten companies posted an average an-nual stock return of 41.4 percent, more than double the S&P 500s average annual re-turn of 18.3 percent. These exceptional returns are due to the ability of these com-panies to generate cash ow. But, as you will see throughout this book, a companycan generate cash ow only if it also creates value for its customers, employees, andsuppliers.3 1

2. 2An Overview of Corporate Finance and the Financial Environment4 CHAPTER 1 An Overview of Corporate Finance and the Financial Environment This chapter should give you an idea of what corporate nance is all about, including an overview of the nancial markets in which corporations operate. But before getting into the details of nance, its important to look at the big picture. Youre probably back in school because you want an interesting, challenging, and rewarding career. To see where nance ts in, lets start with a ve-minute MBA.The Five-Minute MBA Okay, we realize you cant get an MBA in ve minutes. But just as an artist quickly sketches the outline of a picture before lling in the details, we can sketch the key el- ements of an MBA education. In a nutshell, the objective of an MBA is to provide managers with the knowledge and skills they need to run successful companies, so we start our sketch with some common characteristics of successful companies. In particular, all successful companies are able to accomplish two goals. 1. All successful companies identify, create, and deliver products or services that arehighly valued by customers, so highly valued that customers choose to purchasethem from the company rather than from its competitors. This happens only if thecompany provides more value than its competitors, either in the form of lowerprices or better products. 2. All successful companies sell their products/services at prices that are high enoughto cover costs and to compensate owners and creditors for their exposure to risk. Inother words, its not enough just to win market share and to show a prot. TheVisit http://ehrhardt.prot must be high enough to adequately compensate investors.swcollege.com to see theweb site accompanying thisIts easy to talk about satisfying customers and investors, but its not so easy to ac-text. This ever-evolving site,for students and instructors, complish these goals. If it were, then all companies would be successful and youis a tool for teaching, learn- wouldnt need an MBA! Still, companies such as the ones on Fortunes Most Admireding, nancial research, andlist are able to satisfy customers and investors. These companies all share the follow-job searches.ing three key attributes. The Key Attributes Required for Success First, successful companies have skilled people at all levels inside the company, including (1) leaders who develop and articulate sound strategic visions; (2) managers who make value-adding decisions, design efcient business processes, and train and moti- vate work forces; and (3) a capable work force willing to implement the companys strategies and tactics. Second, successful companies have strong relationships with groups that are outside the company. For example, successful companies develop win-win relationships with suppliers, who deliver high-quality materials on time and at a reasonable cost. A related trend is the rapid growth in relationships with third-party outsourcers, who provide high-quality services and products at a relatively low cost. This is particularly true in the areas of information technology and logistics. Successful companies also develop strong relationships with their customers, leading to repeat sales, higher prot margins, and lower customer acquisition costs. Third, successful companies have sufcient capital to execute their plans and sup- port their operations. For example, most growing companies must purchase land, buildings, equipment, and materials. To make these purchases, companies can reinvest a portion of their earnings, but most must also raise additional funds externally, by some combination of selling stock or borrowing from banks and other creditors. 3. An Overview of Corporate Finance and the Financial Environment3How Are Companies Organized? 5Just as a stool needs all three legs to stand, a successful company must have all three attributes: skilled people, strong external relationships, and sufcient capital. The MBA, Finance, and Your Career To be successful, a company must meet its rst goalthe identication, creation, andConsult http://www.delivery of highly valued products and services. This requires that it possess all threecareers-in-nance.com forof the key attributes. Therefore, its not surprising that most of your MBA courses arean excellent site containing directly related to these attributes. For example, courses in economics, communica-information on a variety oftion, strategy, organizational behavior, and human resources should prepare you for abusiness career areas, list- leadership role and enable you to effectively manage your companys work force.ings of current jobs, andother reference materials. Other courses, such as marketing, operations management, and information technology are designed to develop your knowledge of specic disciplines, enabling you to develop the efcient business processes and strong external relationships your company needs. Portions of this corporate nance course will address raising the capital your company needs to implement its plans. In particular, the nance course will enable you to forecast your companys funding requirements and then describe strategies for acquiring the necessary capital. In short, your MBA courses will give you the skills to help a company achieve its rst goalproducing goods and services that customers want. Recall, though, that its not enough just to have highly valued products and satis- ed customers. Successful companies must also meet their second goal, which is to generate enough cash to compensate the investors who provided the necessary capital. To help your company accomplish this second goal, you must be able to evaluate any proposal, whether it relates to marketing, production, strategy, or any other area, and implement only the projects that add value for your investors. For this, you must have expertise in nance, no matter what your major is. Thus, corporate nance is a critical part of an MBA education and will help you throughout your career.What are the goals of successful companies?What are the three key attributes common to all successful companies?How does expertise in corporate nance help a company become successful? How Are Companies Organized? There are three main forms of business organization: (1) sole proprietorships, (2) partnerships, and (3) corporations. In terms of numbers, about 80 percent of businesses are operated as sole proprietorships, while most of the remainder are divided equally between partnerships and corporations. Based on dollar value of sales, however, about 80 percent of all business is conducted by corporations, about 13 percent by sole proprietorships, and about 7 percent by partnerships and hybrids. Because most business is conducted by corporations, we will concentrate on them in this book. However, it is important to understand the differences among the various forms. Sole Proprietorship A sole proprietorship is an unincorporated business owned by one individual. Going into business as a sole proprietor is easyone merely begins business operations. However, even the smallest business normally must be licensed by a governmental unit. 4. 4 An Overview of Corporate Finance and the Financial Environment6 CHAPTER 1 An Overview of Corporate Finance and the Financial Environment The proprietorship has three important advantages: (1) It is easily and inexpen- sively formed, (2) it is subject to few government regulations, and (3) the business avoids corporate income taxes. The proprietorship also has three important limitations: (1) It is difcult for a proprietorship to obtain large sums of capital; (2) the proprietor has unlimited personal liability for the businesss debts, which can result in losses that exceed the money he or she invested in the company; and (3) the life of a business organized as a proprietorship is limited to the life of the individual who created it. For these three reasons, sole proprietorships are used primarily for small-business operations. How- ever, businesses are frequently started as proprietorships and then converted to corporations when their growth causes the disadvantages of being a proprietorship to outweigh the advantages. Partnership A partnership exists whenever two or more persons associate to conduct a non- corporate business. Partnerships may operate under different degrees of formality, ranging from informal, oral understandings to formal agreements led with the secretary of the state in which the partnership was formed. The major advantage of a partnership is its low cost and ease of formation. The disadvantages are similar to those as- sociated with proprietorships: (1) unlimited liability, (2) limited life of the organization, (3) difculty transferring ownership, and (4) difculty raising large amounts of capital. The tax treatment of a partnership is similar to that for proprietorships, but this is often an advantage, as we demonstrate in Chapter 9. Regarding liability, the partners can potentially lose all of their personal assets, even assets not invested in the business, because under partnership law, each partner is liable for the businesss debts. Therefore, if any partner is unable to meet his or her pro rata liability in the event the partnership goes bankrupt, the remaining partners must make good on the unsatised claims, drawing on their personal assets to the extent necessary. Today (2002), the partners of the national accounting rm Arthur Andersen, a huge partnership facing lawsuits led by investors who relied on faulty Enron audit statements, are learning all about the perils of doing business as a partnership. Thus, a Texas partner who audits a business that goes under can bring ruin to a millionaire New York partner who never went near the client company. The rst three disadvantagesunlimited liability, impermanence of the organization, and difculty of transferring ownershiplead to the fourth, the difculty partnerships have in attracting substantial amounts of capital. This is generally not a problem for a slow-growing business, but if a businesss products or services really catch on, and if it needs to raise large sums of money to capitalize on its opportunities, the difculty in attracting capital becomes a real drawback. Thus, growth companies such as Hewlett- Packard and Microsoft generally begin life as a proprietorship or partnership, but at some point their founders nd it necessary to convert to a corporation. Corporation A corporation is a legal entity created by a state, and it is separate and distinct from its owners and managers. This separateness gives the corporation three major advantages: (1) Unlimited life. A corporation can continue after its original owners and managers are deceased. (2) Easy transferability of ownership interest. Ownership interests can be divided into shares of stock, which, in turn, can be transferred far more easily than can proprietorship or partnership interests. (3) Limited liability. Losses are limited to the actual funds invested. To illustrate limited liability, suppose you invested $10,000 in a partnership that then went bankrupt owing $1 million. Because the owners are 5. An Overview of Corporate Finance and the Financial Environment5 How Are Companies Organized? 7liable for the debts of a partnership, you could be assessed for a share of the companysdebt, and you could be held liable for the entire $1 million if your partners could notpay their shares. Thus, an investor in a partnership is exposed to unlimited liability.On the other hand, if you invested $10,000 in the stock of a corporation that thenwent bankrupt, your potential loss on the investment would be limited to your$10,000 investment.1 These three factorsunlimited life, easy transferability of own-ership interest, and limited liabilitymake it much easier for corporations than forproprietorships or partnerships to raise money in the capital markets.The corporate form offers signicant advantages over proprietorships and part-nerships, but it also has two disadvantages: (1) Corporate earnings may be subject todouble taxationthe earnings of the corporation are taxed at the corporate level, andthen any earnings paid out as dividends are taxed again as income to the stockholders.(2) Setting up a corporation, and ling the many required state and federal reports, ismore complex and time-consuming than for a proprietorship or a partnership.A proprietorship or a partnership can commence operations without much paper-work, but setting up a corporation requires that the incorporators prepare a charter and aset of bylaws. Although personal computer software that creates charters and bylaws isnow available, a lawyer is required if the edgling corporation has any nonstandard fea-tures. The charter includes the following information: (1) name of the proposed corpo-ration, (2) types of activities it will pursue, (3) amount of capital stock, (4) number of di-rectors, and (5) names and addresses of directors. The charter is led with the secretary ofthe state in which the rm will be incorporated, and when it is approved, the corporationis ofcially in existence.2 Then, after the corporation is in operation, quarterly and annualemployment, nancial, and tax reports must be led with state and federal authorities.The bylaws are a set of rules drawn up by the founders of the corporation. In-cluded are such points as (1) how directors are to be elected (all elected each year, orperhaps one-third each year for three-year terms); (2) whether the existing stockhold-ers will have the rst right to buy any new shares the rm issues; and (3) proceduresfor changing the bylaws themselves, should conditions require it.The value of any business other than a very small one will probably be maximizedif it is organized as a corporation for these three reasons:1. Limited liability reduces the risks borne by investors, and, other things held con- stant, the lower the rms risk, the higher its value.2. A rms value depends on its growth opportunities, which, in turn, depend on the rms ability to attract capital. Because corporations can attract capital more easily than unincorporated businesses, they are better able to take advantage of growth opportunities.3. The value of an asset also depends on its liquidity, which means the ease of selling the asset and converting it to cash at a fair market value. Because the stock of a corporation is much more liquid than a similar investment in a proprietorship or partnership, this too enhances the value of a corporation.As we will see later in the chapter, most rms are managed with value maximization inmind, and this, in turn, has caused most large businesses to be organized as corpora-tions. However, a very serious problem faces the corporations stockholders, who areits owners. What is to prevent managers from acting in their own best interests, rather1 In the case of small corporations, the limited liability feature is often a ction, because bankers and otherlenders frequently require personal guarantees from the stockholders of small, weak businesses.2 Note that more than 60 percent of major U.S. corporations are chartered in Delaware, which has, over theyears, provided a favorable legal environment for corporations. It is not necessary for a rm to be head-quartered, or even to conduct operations, in its state of incorporation. 6. 6 An Overview of Corporate Finance and the Financial Environment8 CHAPTER 1 An Overview of Corporate Finance and the Financial Environment than in the best interests of the owners? This is called an agency problem, because managers are hired as agents to act on behalf of the owners. We will have much more to say about agency problems in Chapters 12 and 13. Hybrid Forms of Organization Although the three basic types of organizationproprietorships, partnerships, and corporationsdominate the business scene, several hybrid forms are gaining popular- ity. For example, there are some specialized types of partnerships that have somewhat different characteristics than the plain vanilla kind. First, it is possible to limit the liabilities of some of the partners by establishing a limited partnership, wherein certain partners are designated general partners and others limited partners. In a limited partnership, the limited partners are liable only for the amount of their investment in the partnership, while the general partners have unlimited liability. However, the limited partners typically have no control, which rests solely with the general partners, and their returns are likewise limited. Limited partnerships are common in real estate, oil, and equipment leasing ventures. However, they are not widely used in general business situations because no one partner is usually willing to be the general partner and thus accept the majority of the businesss risk, while the would-be limited partners are unwilling to give up all control.The limited liability partnership (LLP), sometimes called a limited liability company (LLC), is a relatively new type of partnership that is now permitted in many states. In both regular and limited partnerships, at least one partner is liable for the debts of the partnership. However, in an LLP, all partners enjoy limited liability with regard to the businesss liabilities, so in that regard they are similar to shareholders in a corporation. In effect, the LLP combines the limited liability advantage of a corporation with the tax advantages of a partnership. Of course, those who do business with an LLP as opposed to a regular partnership are aware of the situation, which increases the risk faced by lenders, customers, and others who deal with the LLP.There are also several different types of corporations. One that is common among professionals such as doctors, lawyers, and accountants is the professional corporation (PC), or in some states, the professional association (PA). All 50 states have statutes that prescribe the requirements for such corporations, which provide most of the benets of incorporation but do not relieve the participants of professional (malpractice) liability. Indeed, the primary motivation behind the professional corporation was to provide a way for groups of professionals to incorporate and thus avoid certain types of unlimited liability, yet still be held responsible for professional liability.Finally, note that if certain requirements are met, particularly with regard to size and number of stockholders, one (or more) individuals can establish a corporation but elect to be taxed as if the business were a proprietorship or partnership. Such rms, which dif- fer not in organizational form but only in how their owners are taxed, are called S corporations. Although S corporations are similar in many ways to limited liability partnerships, LLPs frequently offer more exibility and benets to their owners, and this is causing many S corporation businesses to convert to the LLP organizational form. What are the key differences between sole proprietorships, partnerships, and corporations? Explain why the value of any business other than a very small one will probably be maximized if it is organized as a corporation. Identify the hybrid forms of organization discussed in the text, and explain the differences among them. 7. An Overview of Corporate Finance and the Financial Environment7The Primary Objective of the Corporation 9The Primary Objective of the Corporation Shareholders are the owners of a corporation, and they purchase stocks because they want to earn a good return on their investment without undue risk exposure. In most cases, shareholders elect directors, who then hire managers to run the corporation on a day-to-day basis. Because managers are supposed to be working on behalf of shareholders, it follows that they should pursue policies that enhance shareholder value. Consequently, throughout this book we operate on the assumption that managements primary objective is stockholder wealth maximization, which translates into maxi- mizing the price of the rms common stock. Firms do, of course, have other objectives in particular, the managers who make the actual decisions are interested in their own personal satisfaction, in their employees welfare, and in the good of the community and of society at large. Still, for the reasons set forth in the following sections, stock price maximization is the most important objective for most corporations. Stock Price Maximization and Social Welfare If a rm attempts to maximize its stock price, is this good or bad for society? In general, it is good. Aside from such illegal actions as attempting to form monopolies, vio- lating safety codes, and failing to meet pollution requirements, the same actions that maximize stock prices also benet society. Here are some of the reasons:1. To a large extent, the owners of stock are society. Seventy-ve years ago this was not true, because most stock ownership was concentrated in the hands of a relatively small segment of society, comprised of the wealthiest individuals. SinceThe Security Industry Asso-then, there has been explosive growth in pension funds, life insurance companies,ciations web site, http://and mutual funds. These institutions now own more than 57 percent of all stock. Inwww.sia.com, is a greataddition, more than 48 percent of all U.S. households now own stock directly, assource of information. Tond data on stock owner- compared with only 32.5 percent in 1989. Moreover, most people with a retire-ship, go to their web page,ment plan have an indirect ownership interest in stocks. Thus, most members ofclick on Reference Materials,society now have an important stake in the stock market, either directly or indi-click on Securities Industry rectly. Therefore, when a manager takes actions to maximize the stock price, thisFact Book, and look at the improves the quality of life for millions of ordinary citizens.section on Investor Partici-pation. 2. Consumers benet. Stock price maximization requires efcient, low-cost businesses that produce high-quality goods and services at the lowest possible cost. This means that companies must develop products and services that consumers want and need, which leads to new technology and new products. Also, companies that maximize their stock price must generate growth in sales by creating value for customers in the form of efcient and courteous service, adequate stocks of mer- chandise, and well-located business establishments. People sometimes argue that rms, in their efforts to raise prots and stock prices, increase product prices and gouge the public. In a reasonably competitive economy, which we have, prices are constrained by competition and consumer re- sistance. If a rm raises its prices beyond reasonable levels, it will simply lose its market share. Even giant rms such as General Motors lose business to Japanese and German rms, as well as to Ford and Chrysler, if they set prices above the level necessary to cover production costs plus a normal prot. Of course, rms want to earn more, and they constantly try to cut costs, develop new products, and so on, and thereby earn above-normal prots. Note, though, that if they are indeed successful and do earn above-normal prots, those very prots will attract competition, which will eventually drive prices down, so again, the main long-term beneciary is the consumer. 8. 8An Overview of Corporate Finance and the Financial Environment10 CHAPTER 1 An Overview of Corporate Finance and the Financial Environment3. Employees benet. There are cases in which a stock increases when a company announces a plan to lay off employees, but viewed over time this is the exception rather than the rule. In general, companies that successfully increase stock prices also grow and add more employees, thus beneting society. Note too that many governments across the world, including U.S. federal and state governments, are privatizing some of their state-owned activities by selling these operations to investors. Perhaps not surprisingly, the sales and cash ows of recently privatized companies generally improve. Moreover, studies show that these newly privatized companies tend to grow and thus require more employees when they are managed with the goal of stock price maximization. Each year Fortune magazine conducts a survey of managers, analysts, and other knowledgeable people to determine the most admired companies. One of Fortunes key criteria is a companys ability to attract, develop, and retain talented people. The results consistently show that there are high correlations among a companys being admired, its ability to satisfy employees, and its creation of value for shareholders. Employees nd that it is both fun and nancially rewarding to work for successful companies. So, successful companies get the cream of the employee crop, and skilled, motivated employees are one of the keys to corporate success.Managerial Actions to Maximize Shareholder WealthWhat types of actions can managers take to maximize a rms stock price? To answerthis question, we rst need to ask, What determines stock prices? In a nutshell, it isa companys ability to generate cash ows now and in the future.While we will address this issue in detail in Chapter 12, we can lay out three basicfacts here: (1) Any nancial asset, including a companys stock, is valuable only to theextent that it generates cash ows; (2) the timing of cash ows matterscash receivedsooner is better, because it can be reinvested in the company to produce additional in-come or else be returned to investors; and (3) investors generally are averse to risk, soall else equal, they will pay more for a stock whose cash ows are relatively certainthan for one whose cash ows are more risky. Because of these three facts, managerscan enhance their rms stock prices by increasing the size of the expected cash ows,by speeding up their receipt, and by reducing their risk.The three primary determinants of cash ows are (1) unit sales, (2) after-tax op-erating margins, and (3) capital requirements. The rst factor has two parts, the cur-rent level of sales and their expected future growth rate. Managers can increase sales,hence cash ows, by truly understanding their customers and then providing thegoods and services that customers want. Some companies may luck into a situationthat creates rapid sales growth, but the unfortunate reality is that market saturationand competition will, in the long term, cause their sales growth rate to decline to alevel that is limited by population growth and ination. Therefore, managers mustconstantly strive to create new products, services, and brand identities that cannot beeasily replicated by competitors, and thus to extend the period of high growth for aslong as possible.The second determinant of cash ows is the amount of after-tax prot that thecompany can keep after it has paid its employees and suppliers. One possible way toincrease operating prot is to charge higher prices. However, in a competitive econ-omy such as ours, higher prices can be charged only for products that meet the needsof customers better than competitors products.Another way to increase operating prot is to reduce direct expenses such as laborand materials. However, and paradoxically, sometimes companies can create even 9. An Overview of Corporate Finance and the Financial Environment9The Primary Objective of the Corporation 11higher prot by spending more on labor and materials. For example, choosing thelowest-cost supplier might result in using poor materials that lead to costly productionproblems. Therefore, managers should understand supply chain management, whichoften means developing long-term relationships with suppliers. Similarly, increasedemployee training adds to costs, but it often pays off through increased productivityand lower turnover. Therefore, the human resources staff can have a huge impact on op-erating prots.The third factor affecting cash ows is the amount of money a company must in-vest in plant and equipment. In short, it takes cash to create cash. For example, as apart of their normal operations, most companies must invest in inventory, machines,buildings, and so forth. But each dollar tied up in operating assets is a dollar that thecompany must rent from investors and pay for by paying interest or dividends.Therefore, reducing asset requirements tends to increase cash ows, which increasesthe stock price. For example, companies that successfully implement just-in-time in-ventory systems generally increase their cash ows, because they have less cash tied upin inventory.As these examples indicate, there are many ways to improve cash ows. All of themrequire the active participation of many departments, including marketing, engineer-ing, and logistics. One of the nancial managers roles is to show others how their ac-tions will affect the companys ability to generate cash ow.Financial managers also must decide how to nance the rm: What mix of debt andequity should be used, and what specic types of debt and equity securities should beissued? Also, what percentage of current earnings should be retained and reinvestedrather than paid out as dividends?Each of these investment and nancing decisions is likely to affect the level, tim-ing, and risk of the rms cash ows, and, therefore, the price of its stock. Naturally,managers should make investment and nancing decisions that are designed to maxi-mize the rms stock price.Although managerial actions affect stock prices, stocks are also inuenced by suchexternal factors as legal constraints, the general level of economic activity, tax laws, in-terest rates, and conditions in the stock market. See Figure 1-1. Working within the setof external constraints shown in the box at the extreme left, management makes a set ofFIGURE 1-1 Summary of Major Factors Affecting Stock PricesExternal Constraints:Strategic Policy DecisionsLevel of Economic Conditions in Controlled by Management: Activity andthe Financial1. Antitrust LawsCorporate Taxes Markets2. Environmental 1. Types of Products Regulationsor Services Produced3. Product and Workplace 2. Production Methods Safety Regulations UsedExpected4. Employment3. Research andCash Flows Practices RulesDevelopment Efforts5. Federal Reserve Policy4. Relative Use of DebtFinancing Timing of Stock6. International RulesCash FlowsPrice 5. Dividend Policy Perceived Risk of Cash Flows 10. 10 An Overview of Corporate Finance and the Financial Environment 12CHAPTER 1 An Overview of Corporate Finance and the Financial Environmentlong-run strategic policy decisions that chart a future course for the rm. These policydecisions, along with the general level of economic activity and the level of corporateincome taxes, inuence expected cash ows, their timing, and their perceived risk.These factors all affect the price of the stock, but so does the overall condition of the -nancial markets.What is managements primary objective?How does stock price maximization benet society?What three basic factors determine the price of a stock?What three factors determine cash ows?The Financial MarketsBusinesses, individuals, and governments often need to raise capital. For example,suppose Carolina Power & Light (CP&L) forecasts an increase in the demand forelectricity in North Carolina, and the company decides to build a new power plant.Because CP&L almost certainly will not have the $1 billion or so necessary to pay forthe plant, the company will have to raise this capital in the nancial markets. Or sup-pose Mr. Fong, the proprietor of a San Francisco hardware store, decides to expandinto appliances. Where will he get the money to buy the initial inventory of TV sets,washers, and freezers? Similarly, if the Johnson family wants to buy a home that costs$100,000, but they have only $20,000 in savings, how can they raise the additional$80,000? If the city of New York wants to borrow $200 million to nance a new sewerplant, or the federal government needs money to meet its needs, they too need accessto the capital markets.On the other hand, some individuals and rms have incomes that are greater thantheir current expenditures, so they have funds available to invest. For example, CarolHawk has an income of $36,000, but her expenses are only $30,000, leaving $6,000 toinvest. Similarly, Ford Motor Company has accumulated roughly $16 billion of cashand marketable securities, which it has available for future investments.Types of MarketsPeople and organizations who want to borrow money are brought together with thosewith surplus funds in the nancial markets. Note that markets is pluralthere area great many different nancial markets in a developed economy such as ours. Eachmarket deals with a somewhat different type of instrument in terms of the instrumentsmaturity and the assets backing it. Also, different markets serve different types of cus-tomers, or operate in different parts of the country. Here are some of the major typesof markets:1. Physical asset markets (also called tangible or real asset markets) are those for such products as wheat, autos, real estate, computers, and machinery. Financial asset markets, on the other hand, deal with stocks, bonds, notes, mortgages, and other nancial instruments. All of these instruments are simply pieces of paper with contractual provisions that entitle their owners to specic rights and claims on real assets. For example, a corporate bond issued by IBM entitles its owner to a specic claim on the cash ows produced by IBMs physical assets, while a share of IBM stock entitles its owner to a different set of claims on IBMs cash ows. Unlike these conventional nancial instruments, the contractual provisions of derivatives 11. An Overview of Corporate Finance and the Financial Environment 11 The Financial Markets13 are not direct claims on either real assets or their cash ows. Instead, derivatives are claims whose values depend on what happens to the value of some other asset. Fu- tures and options are two important types of derivatives, and their values depend on what happens to the prices of other assets, say, IBM stock, Japanese yen, or pork bellies. Therefore, the value of a derivative is derived from the value of an underly- ing real or nancial asset.2. Spot markets and futures markets are terms that refer to whether the assets are being bought or sold for on-the-spot delivery (literally, within a few days) or for delivery at some future date, such as six months or a year into the future.3. Money markets are the markets for short-term, highly liquid debt securities. The New York and London money markets have long been the worlds largest, but Tokyo is rising rapidly. Capital markets are the markets for intermediate- or long- term debt and corporate stocks. The New York Stock Exchange, where the stocks of the largest U.S. corporations are traded, is a prime example of a capital market. There is no hard and fast rule on this, but when describing debt markets, short term generally means less than one year, intermediate term means one to ve years, and long term means more than ve years.4. Mortgage markets deal with loans on residential, commercial, and industrial real estate, and on farmland, while consumer credit markets involve loans on autos and appliances, as well as loans for education, vacations, and so on.5. World, national, regional, and local markets also exist. Thus, depending on an organizations size and scope of operations, it may be able to borrow all around the world, or it may be conned to a strictly local, even neighborhood, market.6. Primary markets are the markets in which corporations raise new capital. If Micro- soft were to sell a new issue of common stock to raise capital, this would be a primary market transaction. The corporation selling the newly created stock receives the proceeds from the sale in a primary market transaction.7. The initial public offering (IPO) market is a subset of the primary market. Here rms go public by offering shares to the public for the rst time. Microsoft had its IPO in 1986. Previously, Bill Gates and other insiders owned all the shares. In many IPOs, the insiders sell some of their shares plus the company sells newly created shares to raise additional capital.8. Secondary markets are markets in which existing, already outstanding, securities are traded among investors. Thus, if Jane Doe decided to buy 1,000 shares of AT&T stock, the purchase would occur in the secondary market. The New York Stock Exchange is a secondary market, since it deals in outstanding, as opposed to newly issued, stocks. Secondary markets also exist for bonds, mortgages, and other nancial assets. The corporation whose securities are being traded is not involved in a secondary market transaction and, thus, does not receive any funds from such a sale.9. Private markets, where transactions are worked out directly between two parties, are differentiated from public markets, where standardized contracts are traded on organized exchanges. Bank loans and private placements of debt with insurance companies are examples of private market transactions. Since these transactions are private, they may be structured in any manner that appeals to the two parties. By contrast, securities that are issued in public markets (for example, common stock and corporate bonds) are ultimately held by a large number of individuals. Public securities must have fairly standardized contractual features, both to appeal to a broad range of investors and also because public investors cannot afford the time to study unique, nonstandardized contracts. Their diverse ownership also ensures that public securities are relatively liquid. Private market securities are, therefore, 12. 12An Overview of Corporate Finance and the Financial Environment 14CHAPTER 1 An Overview of Corporate Finance and the Financial Environmentmore tailor-made but less liquid, whereas public market securities are more liquidbut subject to greater standardization. Other classications could be made, but this breakdown is sufcient to show that there are many types of nancial markets. Also, note that the distinctions among markets are often blurred and unimportant, except as a general point of reference. For example, it makes little difference if a rm borrows for 11, 12, or 13 months, hence, whether we have a money or capital market transaction. You should recognize the big differences among types of markets, but dont get hung up trying to distinguish them at the boundaries.A healthy economy is dependent on efcient transfers of funds from people who are net savers to rms and individuals who need capital. Without efcient transfers, the economy simply could not function: Carolina Power & Light could not raise cap- You can access current andital, so Raleighs citizens would have no electricity; the Johnson family would not have historical interest rates and adequate housing; Carol Hawk would have no place to invest her savings; and so on. economic data as well as Obviously, the level of employment and productivity, hence our standard of living, regional economic data for the states of Arkansas, would be much lower. Therefore, it is absolutely essential that our nancial markets Illinois, Indiana, Kentucky,function efcientlynot only quickly, but also at a low cost. Mississippi, Missouri, and Table 1-1 gives a listing of the most important instruments traded in the various - Tennessee from thenancial markets. The instruments are arranged from top to bottom in ascending order Federal Reserve Economic of typical length of maturity. As we go through the book, we will look in much more Data (FRED) site at http:// www.stls.frb.org/fred/. detail at many of the instruments listed in Table 1-1. For example, we will see that there are many varieties of corporate bonds, ranging from plain vanilla bonds to bonds that are convertible into common stocks to bonds whose interest payments vary depending on the ination rate. Still, the table gives an idea of the characteristics and costs of the instruments traded in the major nancial markets. Recent Trends Financial markets have experienced many changes during the last two decades. Tech- nological advances in computers and telecommunications, along with the globalization of banking and commerce, have led to deregulation, and this has increased competition throughout the world. The result is a much more efcient, internationally linked market, but one that is far more complex than existed a few years ago. While these developments have been largely positive, they have also created problems for policy makers. At a recent conference, Federal Reserve Board Chairman Alan Greenspan stated that modern nancial markets expose national economies to shocks from new and unexpected sources, and with little if any lag. He went on to say that central banks must develop new ways to evaluate and limit risks to the nancial system. Large amounts of capital move quickly around the world in response to changes in interest and exchange rates, and these movements can disrupt local institutions and economies. With globalization has come the need for greater cooperation among regulators at the international level. Various committees are currently working to improve coordination, but the task is not easy. Factors that complicate coordination include (1) the differing structures among nations banking and securities industries, (2) the trend in Europe toward nancial service conglomerates, and (3) a reluctance on the part of individual countries to give up control over their national monetary policies. Still, regulators are unanimous about the need to close the gaps in the supervision of worldwide markets. Another important trend in recent years has been the increased use of derivatives. The market for derivatives has grown faster than any other market in recent years, providing corporations with new opportunities but also exposing them to new risks. 13. An Overview of Corporate Finance and the Financial Environment 13The Financial Markets 15 TABLE 1-1 Summary of Major Financial Instruments OriginalInterest RatesInstrument Major ParticipantsRiskMaturityon 9/27/01aU.S. TreasurySold by U.S. Treasury Default-free91 days to 1 year2.3%billsBankers A rms promise to pay, Low if strong Up to 180 days 2.6acceptancesguaranteed by a bankbank guaranteesCommercial Issued by nancially secure Low default riskUp to 270 days 2.4paperrms to large investorsNegotiable Issued by major Depends onUp to 1 year 2.5certicates of banks to large investorsstrength of issuerdeposit (CDs)Money market Invest in short-term debt;Low degree of riskNo specic 3.2mutual funds held by individuals and maturity businesses(instant liquidity)Eurodollar marketIssued by banks outside U.S.Depends onUp to 1 year 2.5time depositsstrength of issuerConsumer creditLoans by banks/credit Risk is variableVariableVariableloansunions/nance companiesCommercial Loans by banksDepends onUp to 7 yearsTied to primeloansto corporations borrower rate (6.0%) orLIBOR (2.6%)dU.S. TreasuryIssued by U.S. government No default risk, but2 to 30 years5.5notes andprice falls if interestbondsrates riseMortgagesLoans secured by property Risk is variableUp to 30 years 6.8MunicipalIssued by state and local Riskier than U.S. Up to 30 years 5.1bondsgovernments togovernment bonds, individuals and but exempt from institutionsmost taxesCorporate bondsIssued by corporations to Riskier than U.S. Up to 40 yearsb7.2 individuals and government debt; institutionsdepends on strength of issuerLeases Similar to debt; rms Risk similar to Generally 3 to Similar to lease assets rather thancorporate bonds 20 yearsbond yields borrow and then buy themPreferred stocks Issued by corporations to Riskier than corporateUnlimited7 to 9% individuals and institutionsbondsCommon stocksc Issued by corporations to Riskier thanUnlimited10 to 15% individuals and institutionspreferred stocksaData are from The Wall Street Journal (http://interactive.wsj.com/documents/rates.htm) or the Federal Reserve Statistical Release, http://www.federalreserve.gov/releases/H15/update. Money market rates assume a 3-month maturity. The corporate bond rate is for AAA-rated bonds.bJust recently, a few corporations have issued 100-year bonds; however, the majority have issued bonds with maturities less than 40 years.c Common stocks are expected to provide a return in the form of dividends and capital gains rather than interest. Of course, if you buy a stock, youractual return may be considerably higher or lower than your expected return. For example, Nasdaq stocks on average provided a return of about 39percent in 2000, but that was well below the return most investors expected.dThe prime rate is the rate U.S. banks charge to good customers. LIBOR (London Interbank Offered Rate) is the rate that U.K. banks charge one another. Derivatives can be used either to reduce risks or to speculate. As an example of a risk- reducing usage, suppose an importers net income tends to fall whenever the dollar falls relative to the yen. That company could reduce its risk by purchasing derivatives that increase in value whenever the dollar declines. This would be called a hedging operation, and its purpose is to reduce risk exposure. Speculation, on the other hand, is done in the hope of high returns, but it raises risk exposure. For example, Procter & 14. 14 An Overview of Corporate Finance and the Financial Environment 16CHAPTER 1 An Overview of Corporate Finance and the Financial EnvironmentGamble lost $150 million on derivative investments, and Orange County (California)went bankrupt as a result of its treasurers speculation in derivatives.The size and complexity of derivatives transactions concern regulators, academics,and members of Congress. Fed Chairman Greenspan noted that, in theory, deriva-tives should allow companies to manage risk better, but that it is not clear whether re-cent innovations have increased or decreased the inherent stability of the nancialsystem.Another major trend involves stock ownership patterns. The number of individu-als who have a stake in the stock market is increasing, but the percentage of corpo-rate shares owned by individuals is decreasing. How can both of these two statementsbe true? The answer has to do with institutional versus individual ownership ofshares. Although more than 48 percent of all U.S. households now have investmentsin the stock market, more than 57 percent of all stock is now owned by pensionfunds, mutual funds, and life insurance companies. Thus, more and more individualsare investing in the market, but they are doing so indirectly, through retirementplans and mutual funds. In any event, the performance of the stock market now has agreater effect on the U.S. population than ever before. Also, the direct ownership ofstocks is being concentrated in institutions, with professional portfolio managersmaking the investment decisions and controlling the votes. Note too that if a fundholds a high percentage of a given corporations shares, it would probably depressthe stocks price if it tried to sell out. Thus, to some extent, the larger institutions arelocked into many of the shares they own. This has led to a phenomenon calledrelationship investing, where portfolio managers think of themselves as having anactive, long-term relationship with their portfolio companies. Rather than beingpassive investors who vote with their feet, they are taking a much more active rolein trying to force managers to behave in a manner that is in the best interests ofshareholders.Distinguish between: (1) physical asset markets and nancial asset markets; (2)spot and futures markets; (3) money and capital markets; (4) primary and sec-ondary markets; and (5) private and public markets.What are derivatives, and how is their value related to that of an underlyingasset?What is relationship investing?Financial InstitutionsTransfers of capital between savers and those who need capital take place in the threedifferent ways diagrammed in Figure 1-2:1. Direct transfers of money and securities, as shown in the top section, occur when a business sells its stocks or bonds directly to savers, without going through any type of nancial institution. The business delivers its securities to savers, who in turn give the rm the money it needs.2. As shown in the middle section, transfers may also go through an investment banking house such as Merrill Lynch, which underwrites the issue. An underwriter serves as a middleman and facilitates the issuance of securities. The company sells its stocks or bonds to the investment bank, which in turn sells these same securities to savers. The businesses securities and the savers money merely pass through the investment banking house. However, the investment bank does buy and hold the 15. An Overview of Corporate Finance and the Financial Environment 15Financial Institutions 17 securities for a period of time, so it is taking a riskit may not be able to resell them to savers for as much as it paid. Because new securities are involved and the corporation receives the proceeds of the sale, this is a primary market transaction.3. Transfers can also be made through a nancial intermediary such as a bank or mutual fund. Here the intermediary obtains funds from savers in exchange for its own securities. The intermediary then uses this money to purchase and then hold businesses securities. For example, a saver might give dollars to a bank, receiving from it a certicate of deposit, and then the bank might lend the money to a small business in the form of a mortgage loan. Thus, intermediaries literally create new forms of capitalin this case, certicates of deposit, which are both safer and more liquid than mortgages and thus are better securities for most savers to hold. The existence of intermediaries greatly increases the efciency of money and capital markets.In our example, we assume that the entity needing capital is a business, and specicallya corporation, but it is easy to visualize the demander of capital as a home purchaser, agovernment unit, and so on.Direct transfers of funds from savers to businesses are possible and do occur on oc-casion, but it is generally more efcient for a business to enlist the services of an invest-ment banking house such as Merrill Lynch, Salomon Smith Barney, Morgan Stanley,or Goldman Sachs. Such organizations (1) help corporations design securities with fea-tures that are currently attractive to investors, (2) then buy these securities from thecorporation, and (3) resell them to savers. Although the securities are sold twice, thisprocess is really one primary market transaction, with the investment banker acting as afacilitator to help transfer capital from savers to businesses.The nancial intermediaries shown in the third section of Figure 1-2 do morethan simply transfer money and securities between rms and saversthey literallycreate new nancial products. Since the intermediaries are generally large, theygain economies of scale in analyzing the creditworthiness of potential borrowers, in FIGURE 1-2 Diagram of the Capital Formation Process1. Direct Transfers Securities (Stocks or Bonds)Business Dollars Savers2. Indirect Transfers through Investment Bankers Securities SecuritiesBusiness Investment BankingSavers HousesDollarsDollars3. Indirect Transfers through a Financial Intermediary Businesss Intermediarys Securities Securities FinancialBusiness Savers Dollars Intermediary Dollars 16. 16An Overview of Corporate Finance and the Financial Environment 18 CHAPTER 1 An Overview of Corporate Finance and the Financial Environment processing and collecting loans, and in pooling risks and thus helping individual savers diversify, that is, not putting all their nancial eggs in one basket. Further, a system of specialized intermediaries can enable savings to do more than just draw interest. For example, individuals can put money into banks and get both interest income and a convenient way of making payments (checking), or put money into life insurance companies and get both interest income and protection for their beneciaries. In the United States and other developed nations, a set of specialized, highly efcient nancial intermediaries has evolved. The situation is changing rapidly, however, and different types of institutions are performing services that were formerly reserved for others, causing institutional distinctions to become blurred. Still, there is a degree of institutional identity, and here are the major classes of intermediaries: 1. Commercial banks, the traditional department stores of nance, serve a widevariety of savers and borrowers. Historically, commercial banks were the major in-stitutions that handled checking accounts and through which the Federal ReserveSystem expanded or contracted the money supply. Today, however, several otherinstitutions also provide checking services and signicantly inuence the moneysupply. Conversely, commercial banks are providing an ever-widening range of ser-vices, including stock brokerage services and insurance.Note that commercial banks are quite different from investment banks. Com-mercial banks lend money, whereas investment banks help companies raise capitalfrom other parties. Prior to 1933, commercial banks offered investment bankingservices, but the Glass-Steagall Act, which was passed in 1933, prohibited commer-cial banks from engaging in investment banking. Thus, the Morgan Bank was bro-ken up into two separate organizations, one of which became the Morgan Guar-anty Trust Company, a commercial bank, while the other became Morgan Stanley,a major investment banking house. Note also that Japanese and European bankscan offer both commercial and investment banking services. This hindered U.S.banks in global competition, so in 1999 Congress basically repealed the Glass-Steagall Act. Then, U.S. commercial and investment banks began merging withone another, creating such giants as Citigroup and J.P. Morgan Chase. 2. Savings and loan associations (S&Ls), which have traditionally served individualsavers and residential and commercial mortgage borrowers, take the funds of manysmall savers and then lend this money to home buyers and other types of borrow-ers. Because the savers obtain a degree of liquidity that would be absent if theymade the mortgage loans directly, perhaps the most signicant economic functionof the S&Ls is to create liquidity which would otherwise be lacking. Also, theS&Ls have more expertise in analyzing credit, setting up loans, and making collec-tions than individual savers, so S&Ls can reduce the costs of processing loans,thereby increasing the availability of real estate loans. Finally, the S&Ls hold large,diversied portfolios of loans and other assets and thus spread risks in a mannerthat would be impossible if small savers were making mortgage loans directly. Be-cause of these factors, savers benet by being able to invest in more liquid, bettermanaged, and less risky assets, whereas borrowers benet by being able to obtainmore capital, and at a lower cost, than would otherwise be possible.In the 1980s, the S&L industry experienced severe problems when (1) short-term interest rates paid on savings accounts rose well above the returns beingearned on the existing mortgages held by S&Ls and (2) commercial real estate suf-fered a severe slump, resulting in high mortgage default rates. Together, theseevents forced many S&Ls to either merge with stronger institutions or closetheir doors. 17. An Overview of Corporate Finance and the Financial Environment 17 Financial Institutions 193. Mutual savings banks, which are similar to S&Ls, operate primarily in the north- eastern states, accept savings primarily from individuals, and lend mainly on a long-term basis to home buyers and consumers.4. Credit unions are cooperative associations whose members are supposed to have a common bond, such as being employees of the same rm. Members savings are loaned only to other members, generally for auto purchases, home improvement loans, and home mortgages. Credit unions are often the cheapest source of funds available to individual borrowers.5. Life insurance companies take savings in the form of premiums; invest these funds in stocks, bonds, real estate, and mortgages; and nally make payments to the beneciaries of the insured parties. In recent years, life insurance companies have also offered a variety of tax-deferred savings plans designed to provide benets to the participants when they retire.6. Mutual funds are corporations that accept money from savers and then use these funds to buy stocks, long-term bonds, or short-term debt instruments issued by businesses or government units. These organizations pool funds and thus reduce risks by diversication. They also achieve economies of scale in analyzing securities, managing portfolios, and buying and selling securities. Different funds are designed to meet the objectives of different types of savers. Hence, there are bond funds for those who desire safety, stock funds for savers who are willing to accept signicant risks in the hope of higher returns, and still other funds that are used as interest-bearing checking accounts (the money market funds). There are literally thousands of different mutual funds with dozens of different goals and purposes.7. Pension funds are retirement plans funded by corporations or government agen- cies for their workers and administered generally by the trust departments of commercial banks or by life insurance companies. Pension funds invest primarily in bonds, stocks, mortgages, and real estate. Changes in the structure of pension plans over the last decade have had a pro- found effect on both individuals and nancial markets. Historically, most large corporations and governmental units used dened benet plans to provide for their employees retirement. In a dened benet plan, the employer guarantees the level of benets the employee will receive when he or she retires, and it is the employers responsibility to invest funds to ensure that it can meet its obligations when its employees retire. Under a dened benet plan, employees have little or no say about how the money in the pension plan is investedthis decision is made by the corporate employer. Note that employers, not employees, bear the risk that investments held by a dened benet plan will not perform well. In recent years many companies (including virtually all new companies, espe- cially those in the rapidly growing high-tech sector) have begun to use dened contribution plans, under which employers make specied, or dened, payments into the plan. Then, when the employee retires, his or her pension benets are de- termined by the amount of assets in the plan. Therefore, in a dened contribution plan the employee has the responsibility for making investment decisions and bears the risks inherent in investments. The most common type of dened contribution plan is the 401(k) plan, named after the section in the federal act that established the legal basis for the plan. Gov- ernmental units, including universities, can use 403(b) plans, which operate essentially like 401(k) plans. In all of these plans, employees must choose from a set of investment alternatives. Typically, the employer agrees to make some dened contribution to the plan, and the employee can also make a supplemental payment. Then, the employer contracts with an insurance company plus one or more mutual fund companies, and then employees choose among investments 18. 18 An Overview of Corporate Finance and the Financial Environment 20 CHAPTER 1 An Overview of Corporate Finance and the Financial Environment Mutual Fund Mania Americans love mutual funds. Just over ten years ago, Amer- market neutral funds, which sell some stocks short, invest icans had invested about $810 billion in mutual funds, whichin other stocks, and promise to do well no matter which way is not exactly chicken feed. Today, however, they have more the market goes. There is the Undiscovered Managers Be- than $5 trillion in mutual funds! havioral fund that picks stocks by psychoanalyzing Wall Not only has the amount of money invested in mutual Street analysts. And then there is the Tombstone fund that funds skyrocketed, but the variety of funds is astounding.owns stocks only from the funeral industry. Thirty years ago there were just a few types of mutual funds.How many funds are there? One urban myth is that there You could buy a growth fund (composed of stocks that paid are more funds than stocks. But that includes bond funds, low dividends but that had been growing rapidly), incomemoney market funds, and funds that invest in non-U.S. funds (primarily composed of stocks that paid high divi-stocks. It also includes avors of the same fund. For exam- dends), or a bond fund. Now you can buy funds that special- ple, some funds allow you to buy different share classes of ize in virtually any type of asset. There are funds that owna single fund, with each share class having different fee stocks only from a particular industry, a particular continent, structures. So even though there are at least 10,000 different or a particular country, and money market funds that invest funds of all types, there are only about 2,000 U.S. equity only in Treasury bills and other short-term securities. There mutual funds. Still, thats a lot of funds, since there are only are funds that have municipal bonds from only one state.about 8,000 regularly traded U.S. stocks. You can buy socially conscious funds that refuse to own stocks of companies that pollute, sell tobacco products, or Sources: The Many New Faces of Mutual Funds, Fortune, July 6, 1998, have work forces that are not culturally diverse. You can buy 217218; Street Myths, Fortune, May 24, 1999, 320.ranging from guaranteed investment contracts to government bond funds to do-mestic corporate bond and stock funds to international stock and bond funds. Un-der most plans, the employees can, within certain limits, shift their investmentsfrom category to category. Thus, if someone thinks the stock market is currentlyovervalued, he or she can tell the mutual fund to move the money from a stockfund to a money market fund. Similarly, employees may choose to gradually shiftfrom 100 percent stock to a mix of stocks and bonds as they grow older.These changes in the structure of pension plans have had two extremely impor-tant effects. First, individuals must now make the primary investment decisions fortheir pension plans. Because such decisions can mean the difference between acomfortable retirement and living on the street, it is important that people coveredby dened contribution plans understand the fundamentals of investing. Second,whereas dened benet plan managers typically invest in individual stocks andbonds, most individuals invest 401(k) money through mutual funds. Since 401(k)dened contribution plans are growing rapidly, the result is rapid growth in themutual fund industry. This, in turn, has implications for the security markets, andfor businesses that need to attract capital. Financial institutions have historically been heavily regulated, with the primary purpose of this regulation being to ensure the safety of the institutions and thus to protect investors. However, these regulationswhich have taken the form of prohibi- tions on nationwide branch banking, restrictions on the types of assets the institutions can buy, ceilings on the interest rates they can pay, and limitations on the types of services they can providetended to impede the free ow of capital and thus hurt the 19. An Overview of Corporate Finance and the Financial Environment19 Financial Institutions 21 TABLE 1-2Ten Largest U.S. Bank Holding Companies and World Banking Companies,and Top Ten Leading UnderwritersPANEL A PANEL BPANEL CU.S. Bank Holding CompaniesaWorld Banking Companiesb Leading UnderwriterscCitigroup Inc.Deutsche Bank, Frankfurt Merrill Lynch & Co.J.P. Morgan Chase Citigroup, New YorkSalomon Smith BarneydBank of America BNP Paribas, Paris Morgan StanleyWells Fargo & Co. Bank of Tokyo-Mitsubishi, TokyoCredit Suisse First BostonBank OneBank of America, Charlotte, N.C. J.P. MorganMetlife Inc UBS, ZurichGoldman SachsFirst Union HSBC Holdings, LondonDeutsche BankFleetBoston Financial Fuji Bank, Tokyo Lehman BrothersU.S. BancorpSumitomo Bank, Osaka UBS WartburgSunTrust Banks Inc. Bayerische Hypo Vereinsbank, MunichBank of America SecuritiesNotes:aRanked by total assets as of December 31, 2000; see http://www.americanbanker.com.bRanked by total assets as of December 31, 1999; see http://www.nancialservicefacts.org/inter__fr.html.c Ranked by dollar amount raised through new issues in 2000; see The Wall Street Journal, January 2, 2001, R19.dOwned by Citigroup.efciency of our capital markets. Recognizing this fact, Congress has authorized somemajor changes, and more are on the horizon.The result of the ongoing regulatory changes has been a blurring of the distinc-tions between the different types of institutions. Indeed, the trend in the United Statestoday is toward huge nancial service corporations, which own banks, S&Ls, in-vestment banking houses, insurance companies, pension plan operations, and mutualfunds, and which have branches across the country and around the world. Examples ofnancial service corporations, most of which started in one area but have now diversi-ed to cover most of the nancial spectrum, include Merrill Lynch, American Ex-press, Citigroup, Fidelity, and Prudential.Panel a of Table 1-2 lists the ten largest U.S. bank holding companies, and Panel bshows the leading world banking companies. Among the worlds ten largest, only two(Citigroup and Bank of America) are from the United States. While U.S. banks havegrown dramatically as a result of recent mergers, they are still small by global stan-dards. Panel c of the table lists the ten leading underwriters in terms of dollar volumeof new issues. Six of the top underwriters are also major commercial banks or are partof bank holding companies, which conrms the continued blurring of distinctionsamong different types of nancial institutions. Identify three ways capital is transferred between savers and borrowers. What is the difference between a commercial bank and an investment bank? Distinguish between investment banking houses and nancial intermediaries. List the major types of intermediaries and briey describe the primary function of each. 20. 20 An Overview of Corporate Finance and the Financial Environment 22 CHAPTER 1An Overview of Corporate Finance and the Financial Environment Online Trading Systems The forces that led to online trading have also promoted on- trading oors of Paris, London, and Frankfurt. Moreover, it line trading systems that bypass the traditional exchanges.recently passed the Chicago Board of Trade (CBOT) to be- These systems, known as electronic communications net- come the worlds leader in futures trading volume. The works (ECNs), use technology to bring buyers and sellers threat of a similar ECN in the United States has undoubt- together electronically. Bob Mazzarella, president of Fi-edly contributed to the recent 50 percent decline in the price delity Brokerage Services Inc., estimates that ECNs have al- of a seat on the CBOT. ready captured 20 to 35 percent of Nasdaqs trading volume.The move toward faster, cheaper, 24-hour trading obvi- Instinet, the rst and largest ECN, has a stake with Gold- ously benets investors, but it also presents regulators, who man Sachs, J. P. Morgan, and E*Trade in another network, try to ensure that all investors have access to a level playing Archipelago, which recently announced plans to form itseld, with a number of headaches. own exchange. Likewise, Charles Schwab recently an-Because of the threat from ECNs and the need to raise nounced plans to join with Fidelity Investments, Donaldson,capital and increase exibility, both the NYSE and Nasdaq Lufkin & Jenrette, and Spear, Leeds & Kellogg to develop plan to convert from privately held, member-owned busi- another ECN. nesses to stockholder-owned, for-prot corporations. ThisECNs are accelerating the move toward 24-hour trading.suggests that the nancial landscape will continue to un- Large clients who want to trade after the other markets have dergo dramatic changes in the upcoming years. closed may utilize an ECN, bypassing the NYSE and Nasdaq.Sources: Katrina Brooker, Online Investing: Its Not Just for Geeks Any-In fact, Eurex, a Swiss-German ECN for trading futuresmore, Fortune, December 21, 1998, 8998; Fidelity, Schwab Part of Deal to contracts, has virtually eliminated futures activity on theCreate Nasdaq Challenger, The Milwaukee Journal Sentinel, July 22, 1999, 1.Secondary Markets Financial institutions play a key role in matching primary market players who need money with those who have extra funds, but the vast majority of trading actually occurs in the secondary markets. Although there are many secondary markets for a wide variety of securities, we can classify their trading procedures along two dimen- sions. First, the secondary market can be either a physical location exchange or a computer/telephone network. For example, the New York Stock Exchange, the American Stock Exchange (AMEX), the Chicago Board of Trade (the CBOT trades futures and options), and the Tokyo Stock Exchange are all physical location exchanges. In other words, the traders actually meet and trade in a specic part of a specic building. In contrast, Nasdaq, which trades U.S. stocks, is a network of linked computers. Other examples are the markets for U.S. Treasury bonds and foreign exchange, which are conducted via telephone and/or computer networks. In these electronic markets, the traders never see one another. The second dimension is the way orders from sellers and buyers are matched. This can occur through an open outcry auction system, through dealers, or by automated order matching. An example of an outcry auction is the CBOT, where traders actually meet in a pit and sellers and buyers communicate with one another through shouts and hand signals. In a dealer market, there are market makers who keep an inventory of the stock (or other nancial instrument) in much the same way that any merchant keeps an inventory. These dealers list bid and ask quotes, which are the prices at which they are 21. An Overview of Corporate Finance and the Financial Environment21 The Stock Market23willing to buy or sell. Computerized quotation systems keep track of all bid and askprices, but they dont actually match buyers and sellers. Instead, traders must contacta specic dealer to complete the transaction. Nasdaq (U.S. stocks) is one such market,as are the London SEAQ (U.K. stocks) and the Neuer Market (stocks of small Ger-man companies). The third method of matching orders is through an electronic communicationsnetwork (ECN). Participants in an ECN post their orders to buy and sell, and theECN automatically matches orders. For example, someone might place an order tobuy 1,000 shares of IBM stock (this is called a market order since it is to buy thestock at the current market price). Suppose another participant had placed an order tosell 1,000 shares of IBM at a price of $91 per share, and this was the lowest price of anysell order. The ECN would automatically match these two orders, execute the trade,and notify both participants that the trade has occurred. Participants can also postlimit orders, which might state that the participant is willing to buy 1,000 shares ofIBM at $90 per share if the price falls that low during the next two hours. In otherwords, there are limits on the price and/or the duration of the order. The ECN willexecute the limit order if the conditions are met, that is, if someone offers to sell IBMat a price of $90 or less during the next two hours. The two largest ECNs for tradingU.S. stocks are Instinet (owned by Reuters) and Island. Other large ECNs includeEurex, a Swiss-German ECN that trades futures contracts, and SETS, a U.K. ECNthat trades stocks. What are the major differences between physical location exchanges and computer/telephone networks? What are the differences among open outcry auctions, dealer markets, and ECNs?The Stock MarketBecause the primary objective of nancial management is to maximize the rms stockprice, a knowledge of the stock market is important to anyone involved in managing abusiness. The two leading stock markets today are the New York Stock Exchangeand the Nasdaq stock market.The New York Stock ExchangeThe New York Stock Exchange (NYSE) is a physical location exchange. It occupies itsown building, has a limited number of members, and has an elected governing bodyits board of governors. Members are said to have seats on the exchange, althougheverybody stands up. These seats, which are bought and sold, give the holder the rightto trade on the exchange. There are currently 1,366 seats on the NYSE, and in August1999, a seat sold for $2.65 million. This is up from a price of $35,000 in 1977. Thecurrent (2002) asking price for a seat is about $2 million.Most of the larger investment banking houses operate brokerage departments, andthey own seats on the NYSE and designate one or more of their ofcers as mem-bers. The NYSE is open on all normal working days, with the members meeting ina large room equipped with electronic equipment that enables each member to com-municate with his or her rms ofces throughout the country. For example, MerrillLynch (the largest brokerage rm) might receive an order in its Atlanta ofce from 22. 22 An Overview of Corporate Finance and the Financial Environment 24 CHAPTER 1An Overview of Corporate Finance and the Financial Environmenta customer who wants to buy shares of AT&T stock. Simultaneously, Morgan Stan-leys Denver ofce might receive an order from a customer wishing to sell shares ofAT&T. Each broker communicates electronically with the rms representative on You can access the homethe NYSE. Other brokers throughout the country are also communicating with their pages of the major U.S.own exchange members. The exchange members with sell orders offer the shares for stock markets by typingsale, and they are bid for by the members with buy orders. Thus, the NYSE operates http://www.nyse.com or http://www.nasdaq.com.as an auction market.3 These sites provide back- ground information as well The Nasdaq Stock Market as the opportunity to obtain individual stock quotes. The National Association of Securities Dealers (NASD) is a self-regulatory body that li-censes brokers and oversees trading practices. The computerized network used by theNASD is known as the NASD Automated Quotation System, or Nasdaq. Nasdaqstarted as just a quotation system, but it has grown to become an organized securitiesmarket with its own listing requirements. Nasdaq lists about 5,000 stocks, although notall trade through the same Nasdaq system. For example, the Nasdaq National Marketlists the larger Nasdaq stocks, such as Microsoft and Intel, while the Nasdaq SmallCapMarket lists smaller companies with the potential for high growth. Nasdaq also oper-ates the Nasdaq OTC Bulletin Board, which lists quotes for stock that is registeredwith the Securities Exchange Commission (SEC) but that is not listed on any exchange,usually because the company is too small or too unprotable.4 Finally, Nasdaq operatesthe Pink Sheets, which provide quotes on companies that are not registered with theSEC. Liquidity is the ability to trade quickly at a net price (i.e. after any commissions)that is very close to the securitys recent market value. In a dealer market, such as Nas-daq, a stocks liquidity depends on the number and quality of the dealers who make a3 The NYSE is actually a modied auction market, wherein people (through their brokers) bid for stocks.Originallyabout 200 years agobrokers would literally shout, I have 100 shares of Erie for sale; howmuch am I offered? and then sell to the highest bidder. If a broker had a buy order, he or she would shout,I want to buy 100 shares of Erie; wholl sell at the best price? The same general situation still exists, al-though the exchanges now have members known as specialists who facilitate the trading process by keepingan inventory of shares of the stocks in which they specialize. If a buy order comes in at a time when no sellorder arrives, the specialist will sell off some inventory. Similarly, if a sell order comes in, the specialist willbuy and add to inventory. The specialist sets a bid price (the price the specialist will pay for the stock) and anasked price (the price at which shares will be sold out of inventory). The bid and asked prices are set at levelsdesigned to keep the inventory in balance. If many buy orders start coming in because of favorable develop-ments or sell orders come in because of unfavorable events, the specialist will raise or lower prices to keepsupply and demand in balance. Bid prices are somewhat lower than asked prices, with the difference, orspread, representing the specialists prot margin.Special facilities are available to help institutional investors such as mutual funds or pension funds selllarge blocks of stock without depressing their prices. In essence, brokerage houses that cater to institutionalclients will purchase blocks (dened as 10,000 or more shares) and then resell the stock to other institutionsor individuals. Also, when a rm has a major announcement that is likely to cause its stock price to changesharply, it will ask the exchanges to halt trading in its stock until the announcement has been made and di-gested by investors. Thus, when Texaco announced that it planned to acquire Getty Oil, trading was haltedfor one day in both Texaco and Getty stocks.4 OTC stands for over-the-counter. Before Nasdaq, the quickest way to trade a stock that was not listed at aphysical location exchange was to nd a brokerage rm that kept shares of that stock in inventory. The stockcerticates were actually kept in a safe and were literally passed over the counter when bought or sold.Nowadays the certicates for almost all listed stocks and bonds in the United States are stored in a vault be-neath Manhattan, operated by the Depository Trust and Clearing Corporation (DTCC). Most brokeragerms have an account with the DTCC, and most investors leave their stocks with their brokers. Thus, whenstocks are sold, the DTCC simply adjusts the accounts of the brokerage rms that are involved, and nostock certicates are actually moved. 23. An Overview of Corporate Finance and the Financial Environment23The Stock Market25Measuring the MarketA stock index is designed to show the performance of theformance. The stocks in the S&P 500 are selected by thestock market. The problem is that there are many stock in-Standard & Poors Index Committee for being the leadingdexes, and it is difcult to determine which index best re- companies in the leading industries, and for accurately re-ects market actions. Some are designed to represent theecting the U.S. stock market. It is value weighted, so thewhole equity market, some to track the returns of certain in- largest companies (in terms of value) have the greatest inu-dustry sectors, and others to track the returns of small-cap, ence. The S&P 500 Index is used as a comparison bench-mid-cap, or large-cap stocks. Cap is short for capitaliza-mark by 97 percent of all U.S. money managers and pensiontion, which means the total market value of a rms stock.plan sponsors, and approximately $700 billion is managed soWe discuss below four of the leading indexes. as to obtain the same performance as this index (that is, inindexed funds).Dow Jones Industrial AverageUnveiled in 1896 by Charles H. Dow, the Dow Jones Indus-Nasdaq Composite Indextrial Average (DJIA) provided a benchmark for comparing The Nasdaq Composite Index measures the performance ofindividual stocks with the overall market and for comparing all common stocks listed on the Nasdaq stock market. Cur-the market with other economic indicators. The industrial rently, it includes more than 5,000 companies, and becauseaverage began with just 10 stocks, was expanded in 1916 tomany of the technology-sector companies are traded on the20 stocks, and then to 30 in 1928. Also, in 1928 The Wall computer-based Nasdaq exchange, this index is generally re-Street Journal editors began adjusting it for stock splits, and garded as an economic indicator of the high-tech industry.making substitutions. Today, the DJIA still includes 30 com-Microsoft, Intel, and Cisco Systems are the three largestpanies. They represent almost a fth of the market value of Nasdaq companies, and they comprise a high percentage ofall U.S. stocks, and all are both leading companies in theirthe indexs value-weighted market capitalization. For thisindustries and widely held by individual and institutional in-reason, substantial movements in the same direction byvestors.these three companies can move the entire index.Wilshire 5000 Total Market IndexRecent PerformanceThe Wilshire 5000, created in 1974, measures the perfor-Go to the web site http://nance.yahoo.com/. Enter themance of all U.S. headquartered equity securities with read-symbol for any of the indices (^DJI for the Dow Jones,ily available prices. It was originally composed of roughly ^WIL5 for the Wilshire 5000, ^SPC for the S&P 500, and5,000 stocks, but as of August 1999, it included more than^IXIC for the Nasdaq) and click the Get Quotes button.7,000 publicly traded securities with a combined market This will bring up the current value of the index, shown in acapitalization in excess of $14 trillion. The Wilshire 5000 istable. Click Chart (under the table heading More Info),unique because it seeks to reect returns on the entire U.S.and it will bring up a chart showing the historical perfor-equity market.mance of the index. Immediately below the chart is a seriesof buttons that allows you to choose the number of years andS&P 500 Index to plot the relative performance of several indices on theCreated in 1926, the S&P 500 Index is widely regarded assame chart. You can even download the historical data inthe standard for measuring large-cap U.S. stock market per- spreadsheet form.market in the stock. Nasdaq has more than 400 dealers, most making markets in alarge number of stocks. The typical stock has about 10 market makers, but somestocks have more than 50 market makers. Obviously, there are more market makers,and liquidity, for the Nasdaq National Market than for the SmallCap Market. Thereis very little liquidity for stocks on the OTC Bulletin Board or the Pink Sheets.Over the past decade the competition between the NYSE and Nasdaq has beenerce. In an effort to become more competitive with the NYSE and with internationalmarkets, the NASD and the AMEX merged in 1998 to form what might best be re-ferred to as an organized investment network. This investment network is often referred 24. 24 An Overview of Corporate Finance and the Financial Environment 26CHAPTER 1 An Overview of Corporate Finance and the Financial Environmentto as Nasdaq, but stocks continue to be traded and reported separately on the twomarkets. Increased competition among global stock markets assuredly will result insimilar alliances among other exchanges and markets in the future.Since most of the largest companies trade on the NYSE, the market capitalization ofNYSE-traded stocks is much higher than for stocks traded on Nasdaq (about $11.6 tril-lion compared with $2.7 trillion in late 2001). However, reported volume (number ofshares traded) is often larger on Nasdaq, and more companies are listed on Nasdaq.5Interestingly, many high-tech companies such as Microsoft and Intel have re-mained on Nasdaq even though they easily meet the listing requirements of theNYSE. At the same time, however, other high-tech companies such as Gateway 2000,America Online, and Iomega have left Nasdaq for the NYSE. Despite these defec-tions, Nasdaqs growth over the past decade has been impressive. In the years ahead,the competition will no doubt remain erce.What are some major differences between the NYSE and the Nasdaq stockmarket?The Cost of MoneyCapital in a free economy is allocated through the price system. The interest rate is theprice paid to borrow debt capital. With equity capital, investors expect to receive dividends andcapital gains, whose sum is the cost of equity money. The factors that affect supply and de-mand for investment capital, hence the cost of money, are discussed in this section.The four most fundamental factors affecting the cost of money are (1) productionopportunities, (2) time preferences for consumption, (3) risk, and (4) ination.To see how these factors operate, visualize an isolated island community where thepeople live on sh. They have a stock of shing gear that permits them to survive rea-sonably well, but they would like to have more sh. Now suppose Mr. Crusoe has abright idea for a new type of shnet that would enable him to double his daily catch.However, it would take him a year to perfect his design, to build his net, and to learnhow to use it efciently, and Mr. Crusoe would probably starve before he could put hisnew net into operation. Therefore, he might suggest to Ms. Robinson, Mr. Friday, andseveral others that if they would give him one sh each day for a year, he would returntwo sh a day during all of the next year. If someone accepted the offer, then the shthat Ms. Robinson or one of the others gave to Mr. Crusoe would constitute savings;these savings would be invested in the shnet; and the extra sh the net producedwould constitute a return on the investment.Obviously, the more productive Mr. Crusoe thought the new shnet would be, themore he could afford to offer potential investors for their savings. In this example, weassume that Mr. Crusoe thought he would be able to pay, and thus he offered, a 100percent rate of returnhe offered to give back two sh for every one he received. Hemight have tried to attract savings for lessfor example, he might have decided to of-fer only 1.5 sh next year for every one he received this year, which would represent a50 percent rate of return to potential savers.How attractive Mr. Crusoes offer appeared to a potential saver would depend inlarge part on the savers time preference for consumption. For example, Ms. Robinsonmight be thinking of retirement, and she might be willing to trade sh today for sh5 One transaction on Nasdaq generally shows up as two separate trades (the buy and the sell). This doublecounting makes it difcult to compare the volume between stock markets. 25. An Overview of Corporate Finance

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